Rate Increase May Prompt Stampede from Bonds

Large holdings of bond mutual funds and exchange-traded funds (ETFs) may facilitate a disorderly stampede out of corporate bonds if interest rates rise, predicts a Bank of America analyst, according to CNBC.

Rising rates typically prompt investors to sell bonds, but in the past corporate bonds were illiquid investments, usually held to maturity or until called.

When interest rates rose in 1994 and 1999, investors withdrew about 10 percent of their total assets out of corporate bonds, CNBC notes. The stupendous growth of retail investors holding bond mutual funds and ETFs have changed the situation.

Corporate bonds represent 42 percent of mutual fund assets, compared with 24 percent in 1994 and 31 percent in 1999, according to CNBC. Since mutual funds and ETFs own almost a fifth of the corporate bond market, if rates rise, investors could easily dump their mutual funds and ETFs.

“Thus, if we were to experience outflows from bond funds of the magnitude seen in 1994 and 1999, the impact on corporate bonds this time would be much more severe,” Hans Mikkelsen, credit strategist at BofA, writes in a note to clients, according to CNBC. “There is reason to suspect that households will play a more active role in rebalancing out of bonds, into stocks as interest rates increase.”

The risk to corporate bonds, he warns, will greatly increase if the 10-year Treasury rate, now slightly over 2 percent, passes 3 percent.

“A disorderly rotation out of bonds — characterized by higher interest rates and wider credit spreads — is the biggest risk for investment grade corporate bond investors this year,” Mikkelsen warned. “However, history offers little guidance about how much of an increase in interest rates would prompt such disorderly scenario and how it would play out.”

The risk of loss is high for corporate bond holders if interest rates rise, but the extent of losses depends on several variables, especially the speed of interest rate increases, says Fitch Ratings in its report “The ‘Bond Bubble’: Risks and Mitigants.”

If rates quickly jumped 2 percentage points, a typical 10-year BBB corporate bond could lose 15 percent of its market value. If rates rose gradually, losses would be mitigated by the coupon income received and the shorter remaining maturity.

“While a continuation of accommodative monetary policy would reduce the likelihood of a sudden spike in rates,” Fitch states, “it could exacerbate existing imbalances, as an increasing share of investor portfolios would consist of lower coupon securities that are particularly vulnerable to rising rates.”